Second Quarter Review

Stocks had a strong quarter as interest rates continued to move lower. With the recent rebound of both the Canadian dollar and commodity prices, Canadian stocks returned 4.2%, but are still in negative territory when compared to a year ago. In the last quarter the US stock market gained an encouraging 1.9% as compared to only 1.9% for the entire prior year. The US dollar has recaptured some of the previous year’s gains.

With stocks near record highs, the margin of safety from cheap valuations has been reduced, thus we are tempering our bullishness towards global equity markets. We are in an environment where valuations are full, global economic growth remains somewhat tepid and there is increased political risks related to Brexit  and the upcoming US presidential election.

Valuations are still reasonable based on 2017 S&P 500 earnings estimates. The US stock market has largely gone sideways as 2016 earnings are forecasted to be flat relative to 2015 earnings. If anything, valuations are stretched based on current profits leaving little margin for error. US corporate earnings stagnation is due to slower economic growth (particularly outside North America) and last year's US dollar strength depressing foreign earnings.

As both the bull market and economic cycle age, we are highly focused on the potential risks of reduced global growth expectations. Let's be clear, we do not see an impending recession. The upside in stocks continues to outweigh the downside, an environment where the risks are also increasing. We believe this is a time when an experienced portfolio manager can add value.

The good news is that the current earnings growth recession is poised to end. As the US dollar partially regains lost territory, this translates into a relatively improved profit outlook. This improvement in the US dollar exchange rate comparables should help the S&P 500 profits begin growing by late summer. US earnings revisions have turned positive for the first time since 2014. This environment of favourable earnings momentum is typically positive for equity performance. The two biggest drivers for the upward earnings revisions is the weaker US dollar and the recent recovery in commodity (and specifically oil) prices.

Oil production is mostly in balance with demand resulting in oil prices rising significantly from the bottom, yet still off their highs. The rise in oil prices has probably peaked in the short term with the current price becoming the new normal. Oil prices benefited from unscheduled supply disruptions in both Canada and Nigeria. Oil at $50 allows some capital expenditures to return to the sector, but not the unconstrained spending on shale fracking that we saw a few years ago. Energy prices remain low enough that consumers will not be materially impacted by the recent rise, but high enough that most production companies with reasonable costs will be profitable. The marginal high cost producers will not be incentivized to drill, limiting the likelihood of a return to an oversupplied market.

The economic cycle is aging. Investors are nervous and are selling stocks based on any indication (no matter how minor) that economic growth might be slowing. The risk is not so much that we will enter a severe recession as we did seven years ago, but that this “muddle along” economy with 2% growth turns into a no growth scenario. Central banks around the world have been highly accommodative trying to stimulate the global economy with the provision of zero to negative interest rates. The Bank of Japan is ramping up their easing program while the European Central Bank has started their bond buying program. The Fed began their tightening program in December, yet they have not raised rates since. It is highly likely that if they do raise rates again this year, they will only do so once. While it has been almost 7 years since the end of the recession, US GDP growth has only averaged 2% / year during that timeframe. This is the most tepid economic recovery we have experienced over the last 100 years. Although 2% is nothing to write home about, it remains stronger than comparative European and Japanese growth rates.

Bonds continue to provide safety vis-vis a return of capital. From a return on capital perspective, bonds are less attractive. Super low bond yields results in miniscule bond returns, assuming there is no material change in interest rates. We continue to believe that stocks, judiciously chosen, will provide higher returns than bonds. The dividend yield on equities is higher than 10 year government bond yields for the first time in 35 years. This typically results in stocks outperforming bonds.

With relatively pricey stock valuations, we are cognizant that if the forecast for growth prove overly optimistic there may be a reactive increase in market volatility. If this should transpire, we advise our investors to remain confident in their investment plan. After six sluggish months, economic growth remains poised to accelerate. This should provide a background for the equity markets to advance higher.